by Andrew Stewart, Chief Operating Officer
DAVID CRONHEIM MORTGAGE CORP.
David Cronheim Mortgage Corp., mortgage banker and debt adviser to institutional investors, is one of the country’s oldest privately-held real estate investment banks. Founded in 1897, DCMC currently oversees an investment portfolio of over $1.3 billion from its offices in Chatham, NJ.
“Managing expectations” ranks among the most useful, if underused, concepts in business and in life. It is the attempt to ensure that a person’s projected reality does not exceed what one can reasonably expect to occur. In the case of real estate investing, owners of equity and debt should have an understanding of expected benefits - and risks. Today, the community marketing these investments to the buying public is doing a credible job of potential benefit education; its effort in potential risk education, however, is another story altogether. The real estate community will suffer less dislocation and stress in the long run if expectations are well managed.
To start, let’s examine the basic premise upon which real estate investors found their favorable view of real estate. A common phrase such as “they aren’t making any more of it” or the concept of rent inflation over time forms the bedrock of most investors’ thought processes. To take this to its logical conclusion, David Ricardo (1772-1823), a pioneer who helped give economics its modern structure, can help. He looked at the factors determining prices, rents, wages and profits with a sense of system that has served economists ever since. Ricardo regarded population as a dependent variable – it “regulates itself by the funds which are to employ it, and therefore always increases or diminishes with the increase or diminution of capital.” Increased wealth and productivity bring more people but not more land. As a result, those who own land are able to command an increased return for an increasingly scarce commodity. “Every rise in profits” on the other hand, “is favourable to the accumulation of capital, and to the further increase of population, and therefore would, in all probability lead to an increase in rent”. Sounds like some good reasons to invest in real estate in the enormous U.S. economy — two-and-a-half times as big as the next largest economy in the world and almost as large as that of the other members of the Group of Eight combined, not to mention the G8’s most stable political environment.
Alas, but there are other factors that impact value: the availability and cost of capital, the cost to operate real estate, legislative incentives or disincentives, and users’ ability to pay (for rent or purchase) from funds generated through income or reserves. Then, of course, the microeconomic factors of supply and demand in each submarket also directly affect value.
Nearly 50 years ago, the recently deceased economist John Kenneth Galbraith coined the phrase “Conventional Wisdom” as the continuum of ideas that are esteemed at any point in time for their acceptability. Conventional wisdom becomes a sort of comfort zone where everyone who abides by it takes solace in knowing that his or her contemporaries take the same view. This does not mean that the conventional wisdom is always correct. Galbraith goes on to say that the “correct” conventional wisdom of today may not be true tomorrow. A changing environment can deal a fatal blow to the conventional wisdom when those ideas fail to respond to some contingency that threatens to render them obsolete. Real estate conventional wisdom is also subject to change; some of the following widely-held assumptions may have obsolescence creeping in.
Rents for many types of real estate are currently increasing. Demand for hotel rooms and office space in many supply-constrained markets lead the way, as does multifamily, where the rent-to-own ratio remains lopsided in the renters’ favor. There are many other markets, however, where job losses and/or excess supply will constrain rent growth for the foreseeable future.
Other than labor costs, there often exists little
correlation between rent and expense inflation. Rising rents usually signal a
local economy strong enough to put upward pressure on wages. By contrast, real
estate taxes, utilities and insurance may rise independent of rents; just ask
anyone in the Southeast and Texas now attempting to procure property and
casualty insurance. Convention
wisdom in the crude market has changed radically since 1998
Investors pay top dollar
and accept lower yields for properties in the best locations that have the
highest rents. Assumptions are lowered for vacancy rates, turnover frequency
yield requirements, and increased for rent inflation. Some of us may question
the conventional wisdom here, since vacancy, turnover, and yield requirements
can increase at the same time that rent is falling. Look at San Francisco
office values in 2000 and then 3 years later ;
an “investment grade” market that took quite a tumble. Are the immense premiums
paid for top-tier real estate actually worth it?
AAA CMBS issued in 1997 had
subordination levels in the
in the 3rd quarter of 2002, Moody’s stressed debt service coverage
ratios hovered in the 1.20 range. By contrast, current AAA’s have subordination
levels of 15% and Moody’s stressed debt service coverage ratios of 0.98.
Combined with the widespread use of interest-only periods and the higher
leverage (AAA’s now have lower subordination levels on much higher valuations),
it is clear that the risk profile of these bonds has increased even though they
are still marketed as “AAA.”
Some in the bond buying
community acknowledge these changes. Yet market behavior demonstrates that
AAA’s are, if anything, considered safer today than 10 years ago. Lower spreads
have been achieved within the context of a maturing marketplace touting solid
repayment history, better information flow, larger and more diverse pool sizes,
and fewer exotic properties types such as healthcare, golf courses and marinas.
The emergence of cross
According to Moody’s and Standard and Poors, a AAA security is defined as one whose capacity to meet its financial obligation is extremely strong. Maybe “extremely strong” could be replaced with “pretty good”.
Many believe that the long-term outlook for housing
remains excellent, and it probably is. In the short term, however, homebuyers
must overcome several obstacles. As noted earlier, taxes, insurance, and
utilities have all risen recently. This, combined with teaser rates offered on
many home mortgages, stirs trouble on the horizon. Over $1 trillion of
adjustable rate mortgages – 12% of total U.S. outstanding mortgage debt – will
roll to market rates in 2007
(NY Times; June 15, 2005); adding in amortization will cause some
initial payments to triple or quadruple. For example, a $200,000 home loan with
an initial teaser payment of $400 per month
Most people take for granted the notion that capital will always be available for real estate. Those who entered the industry after 1995 have never seen a time (except for short-lived periods in late 1998 and post-9/11) without liquidity for real estate. If some of the aforementioned (net income deflation, losses in commercial mortgages and reduced values) actually happens, liquidity would leave the market. Values in this scenario would plummet.
As long as investors in real estate understand the risks associated with it, their expectations can be properly managed. The massive increases in value that have occurred over the past 15 years cannot continue unabated. The stability resulting from properly managed expectations can allow the health that the market currently enjoys to continue. There is nothing wrong with an investor occasionally losing money in real estate, as this alone will not create a massive dislocation and subsequent heartache for the economy. Unfortunately, those who believe in possibly obsolete conventional wisdom may not be managing their own expectations of potential losses. Therein lies the problem.
Behavioral economist Michael McBride of University of California at Irvine studies happiness and its causes. “People ask me all the time, ‘What do you learn about happiness? What’s the secret to happiness?’” McBride said. His standard answer, only half kidding: “Low expectations”.
Sources: Moody’s Investor Survey; JP Morgan CMBS Report; New York Times; The Affluent Society, John Kenneth Galbraith; Los Angeles Times.
205 Main Street, PO Box 807, Chatham, NJ 07928 • Tel: 973.635.6800 • Fax: 973.635.6091
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